Power Crisis Can Cost You

CHET CURRIER FUND WATCH

California's electric-power crisis is giving investors with almost $2 trillion in money-market mutual funds a fast refresher course in what they own.

So far, it doesn't appear this lesson will cost us (I'm in there too) any financial loss. Assuming that we do come through unscathed, however, it should leave us less complacent.

In a mere 30 years since the first money fund opened, these funds have become a pillar of the financial system. For millions of savers and investors, they have supplanted the passbook savings account as a place to hold cash. They attract corporations and institutions of every sort as well as individuals.

Right now, on average, money funds are paying a return at the annual rate of $57 for each $1,000 invested, compared with $37 in comparable bank accounts.

There's another key difference: while most U.S. bank accounts are covered by federal deposit insurance, money funds are not. They aim to keep their investors' principal intact by maintaining a constant net asset value per share of $1. But they don't promise to do that.

In practice, it has become well nigh unthinkable for any substantial money fund to "break the buck," especially as these funds have doubled in size in the last four years. Consider this example:

Suppose the Mighty Money Market Fund has 5 percent of its assets invested in commercial paper, or short-term unsecured IOUs, issued by electric utilities in California. Then suppose that after those utilities fail to make timely payment of interest and principal, the paper trades at 50 cents on the dollar while investors wait to see what happens next.

If events were left to unfold on their own, you'd see Mighty's net asset value fall to 97.5 cents a share as its holdings are marked to market. One event like that per year in a money fund yielding 5.5 percent would effectively lower its return to 3 percent. In itself, disappointing -- but not calamitous.

Ah, but there's more to markets than numbers. Even a single instance of breaking the buck would demolish a presumption of stability underlying all money funds, and disturb the whole financial system.

See the tumbling dominoes as investors flee for safer harbors! Why, you could write a potboiler novel imagining the disaster that would ensue.

Since nobody wants to watch this drama played out in real life, safeguards have been set up. Strict rules limit the risks money fund managers can take. Many funds buy private insurance.

When something does go wrong from time to time with a security owned by a money fund, a standard solution has evolved. The firm that manages the fund buys the security from the fund (a separate entity owned by its investors) at 100 cents on the dollar. Presto, the problem vanishes from the fund, transplanted into the manager's own account.

Funny thing, though. Each time this happens, it increases investors' expectation that it will always happen. Before you can say "moral hazard," that presumption becomes a supporting beam of the whole money market. For perspective, according to the Investment Company Institute, money funds buy about 45 percent of all commercial paper.

What happens if, someday, defaults occur in sufficient size and quantity that fund managers lack the resources to bail their funds out? Everybody figures the powers-that-be in Washington will step into the breach.

This creates an implied guarantee. "Implied guarantee" is a contradiction in terms, of course. The first job of every money fund investor is never to overlook that word "implied."

Now, back to the present case. "We do not expect any money funds to be in danger of breaking the buck on this," says Peter Crane, managing editor of The Money Fund Report, which is published by iMoneyNet Inc. in Westborough, Mass. "But I would not be surprised to see a handful of bailouts."

The system, we hope, will prove itself resilient again. But as the California short-circuit story plays out, it gives every investor pause. We're reminded to stay diversified, lean toward the big, top-quality money funds, and avoid complacency about all things financial -- even something as stodgy as a money market fund.

Chet Currier is a Bloomberg News columnist. He can be reached at ccurrier@bloomberg.net.